Understanding the Limited Life of the Call

You can become a call buyer simply for the potential profit you could earn within a limited period of timeâin other words, buying purely on the chance of earning a profit in the short term. That profit will be realized if and when the call's premium value increases, so that the call can be sold for more than it cost, or by exercising the call and buying 100 shares of stock below current market value.

The call also can be used to offset losses in a short position held in the underlying stock.

The buyer's risks are not the same as those for sellers; in fact, they often are the exact opposite. Before becoming an options buyer, examine all of the risks, become familiar with potential losses as well as potential gains, and review risk from both sides: as potential buyer or seller. Time value evaporates with ever-increasing speed as expiration nears, which is a disadvantage to you as a buyer but an advantage to the seller. Time is a significant factor that affects your decision about when to close out your long position in the option. Because time value disappears by the point of expiration, time itself dictates which options you can afford to buy, and which ones are long shots. More time value usually means more time until expiration, and more price movement that you will need to make a profit. In fact, even when the stock price movement goes the way you want, you still might not make a profit; price movement has to exceed the number of points of time value and more to produce a profit.

This is where comparisons between listed options and LEAPS options become interesting. For example, you might look at side-by-side options with identical striking prices and come to different conclusions about their viability.

Example

Into the Stretch: A stock is currently valued at $48 per share. The 50 call expires in eight months and is currently selling for 3. If you buy that call, it will be necessary for the stock to rise at least five points to $53 per share before expiration, just to cover your costs before trading fees (such a rise would produce intrinsic value of 3 points, producing breakeven before trading fees).

Example

Taking the LEAPS: The picture is far different when a LEAPS call is reviewed. For the same stock, currently valued at $48, the 50 call that expires in 29 months is valued at 9. In this situation, the call costs three times moreâ$900 versus $300âbut you have 30 months for the stock to move, instead of eight months. You would need the stock to rise 11 points, to $59 per share, to break even in this case.

Which of these scenarios is better? You can buy a short-term call for 3 or a long-term LEAPS call for 9. Depending on the stock and its price volatility, your opinion about future price movement, and your personal risk profile, you could decide to go with either of these calls, or decide to take no action.

Smart Investor Tip

Time works against you as a buyer, so the more time value in the option you buy, the more difficult it will be to make a profit.

Buying short-term options or LEAPS options are not your only choices. A comparison between purchasing stock as a long-term investment and purchasing calls for short-term profit points out the difference between investment and speculation. Typically, speculators accept the risk of loss in exchange for the potential for profit, and they take their positions in short-term instruments such as options for the exposure to that potential. Because a relatively small amount of money can be used to tie up 100 shares of stock, call buying is one form of leverage, a popular strategy for making investment capital go further. Of course, the greater the degree of leverage, the greater the associated risk.

When you consider the interaction between intrinsic and time value of calls, you quickly realize that time itself plays a very crucial role in option value. The longer the time until expiration, the more complicated this relationship becomes. For this reason, the LEAPS option presents many interesting possibilities for speculators.

Intrinsic value rises and falls to match the underlying stock's price. But because a LEAPS call is long-term, the action of time value often obscures the relationship between intrinsic value and underlying stock price. It might appear as though the call's value is not tracking the stock point for point. With a lot of time value remaining in a call's premium (including both time and extrinsic segments), it is possible that the call's value will not respond to changes in the stock as clearly as it does when expiration is imminent.

Example

Making the Long Call: You purchased a LEAPS call last month with a striking price two points above market value of the underlying stock. Since then, the stock's price has risen and the LEAPS call is now in the money. But you have noticed that as the stock's market value rises and falls, the LEAPS call tends to duplicate the change only about 75 percent (so when the stock rises one point, the call rises 75 cents). This is caused by changes in perception of extrinsic value, offsetting the tendency of intrinsic value by itself.

The complexity here is that intrinsic value is not entirely isolated from the call's extrinsic value. Two things occur as expiration nears. First, the pure time value premium tends to deteriorate at an accelerated rate. Second, extrinsic value is likely to disappear altogether. If you think of extrinsic value as "potential value" of the call, it makes sense. In other words, extrinsic value exists because of perception that profits may be possible in the call position due to (1) time remaining until expiration; (2) volatility of the underlying stock; and (3) proximity of the striking price and current market value. So in the case of a LEAPS call with many months to go until expiration, a change in the underlying stock will also affect perceptions about the investment or speculative value of the call. Extrinsic value is then likely to affect option value directly.

As expiration approaches, extrinsic value becomes a smaller factor and will disappear from the picture altogether. But as long as many months remain until expiration, intrinsic value cannot operate independently. Some nonintrinsic changes will occur as well. This may be seen as point changes lower than changes in the underlying stock's value, or point changes higher than the point change in the underlying stock. That is the effect of extrinsic value interacting not only with time but also with intrinsic value.

Is call speculation appropriate for you? Questioning risk levels is necessary for every investor and should be an ongoing process of self-examination. Knowing exactly what you are getting into, determining the best strategy, and fully comprehending the risk add up to the measure of your suitability for a particular investment or strategy. Suitability identifies what is appropriate given your income, sophistication, experience, understanding of markets and risks, and capital resources. Avoid the problem of understanding the profit potential of a strategy but not the full extent of risk.

Example

My Friend Told Me: An investor has no experience in the market, having never owned stock; he also does not understand how the market works. He has $1,000 available to invest today, and decides that he wants to earn a profit as quickly as possible. A friend told him that big profits can be made buying calls. He wants to buy three calls at 3 each, requiring $900, plus trading fees. He expects to double his money within one month.

This investor would not meet the minimum suitability standards for buying calls. He does not understand the market, know the risks, or appreciate the specific details of options beyond what a friend told him. He probably does not know anything about time value and the chance of losing money from buying calls. He is aware of only the profit potential, and that information is incomplete. In this situation, the broker is responsible for recognizing that option buying would not be appropriate. One of the broker's duties is to ensure that clients know what they are doing and understand all of the risks. The broker's duty is to refuse to execute the transaction. This does not mean that every broker will follow that rule.

Suitability refers not only to your ability to afford losses, but also to your understanding of the many forms of risk in the options market. If the investor in the preceding example worked with an experienced broker at the onset, it would also make sense to listen to that broker's advice about a proposed option position.

By Michael C. Thomsett

Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.